Legal counsel and compliance officers at investment banks say proposed regulations that would require brokers to carry out real-time monitoring of algo trading would be operationally difficult.
Panellists at the recent Trading Architecture Asia forum note industry fear over technology such as "kill switch" -- which equity trading desks at investment banks have been using to terminate clients' direct access to an exchange -- because of the potential for being held liable by regulators.
A new regulatory framework on algorithmic trading, proposed recently by regulators in Australia, would see brokers accountable if they did not apply kill switch to prevent market misconduct, a term whose interpretation can vary from firm to firm.
Mark Wan, legal counsel for SocGen, notes that whereas in the past a decision to terminate such exchange access has been at a broker’s discretion, in future the onus would be on a broker to use controls and switches to protect market integrity.
It follows events such as Knight Capital’s algo malfunction in August, when the electronic market-maker sent aberrant orders to market and caused erroneous trading in over 100 stocks on the New York Stock Exchange.
“Particularly with market misconduct …[it is] one of the hardest offences to prove when it comes to establishing intent," says Wan. "It is fair to say most firms that are found to be manipulating markets elsewhere…[these manipulations] are done inadvertently."
There is no consensus over how such controls could be applied to protect market integrity, Wan says, so many questions remain unanswered.
Kaz Kempers, head of IT at ABN Amro Clearing in Hong Kong, notes it has had kill switch in place for all direct market access to clients in the region. But whether these terminations should be triggered manually or automatically to kill connection to an exchange is uncertain.
“For HFT it is easier to have an automatic trigger because by the time the algo goes rogue…with the high amount of orders you might not be fast [enough] with a manual switch,” said Kempers.
But the risk of automatically triggering a kill switch is that such a decision could ruin a client’s trading strategy. Some clients will be trading a position in one market and hedging that position in another, and a trigger might be pulled unnecessarily and sour a client's commercial relationship.
“It is hard to find people who are able to interpret the code of the clients…[the new regulatory regime] calls for a risk manager that has programming experience,” says Kempers.
He argues that risk limits should be implemented at several layers of intermediaries and operators involved in trading execution. While exchanges and brokers/clearers should have risk limits, trading firms themselves should also develop their own ability to set risk limits on their trading algorithms for the purpose of survival. In the case of Knight Capital, for example, the erroneous trading positions sent to the exchange caused the firm a pre-trade loss of $440 million.
Shaun Ansell, head of legal and compliance at Mizuho Securities Asia, said the requirement for real-time monitoring and use of kill switch would require more staff to watch clients trading algos continuously.
Another potentially trickier consideration is where in a firm's hierarchy a decision to apply kill switch should come from.
“If real-time monitoring comes to a point where we have to decide whether to apply a kill switch," says Ansell, "who are the right people in the firm to make that decision? Is it the trader or compliance? Also, considering the customer’s relationship with the firm, does that decision need to escalate to senior management?”
The new regulatory regime governing equity market structure and automated trading proposed by the Australian Securities & Investments Commission requires market participants to exercise automated controls, such as kill switch, if it has identified that trading messages from a client are interfering with market efficiency and integrity.
Similarly, in Hong Kong the Securities and Futures Commission has also proposed requiring brokers to have controls to prevent algos from sending manipulative, abusive or erroneous orders. Both consultations periods over the proposed new regulations close this month.